Ontario Court of Appeal Rules on the Enforceability of Restrictive Covenants on the Sale of a Business

The Court of Appeal for Ontario has ruled that non-competition clauses and other restrictive covenants entered into on the sale of a business will be unenforceable if their duration is tied to the disposition of equity interests and if the consent of third parties is required for the disposition. In Martin v. ConCreate USL Limited Partnership,1 the Court found that restrictive covenants whose duration depended on obtaining consents from third parties were unreasonable because they are indeterminate in time frame, with no fixed, outside term limit. The case highlights that while restrictive covenants entered into on the sale of a business are given greater deference than those entered into in the employment context, they are not immune from judicial scrutiny.

Background

Martin was a 20-year employee, president and a minority shareholder of ConCreate and a related business, Steel Design & Fabricators (SDF). The businesses were sold to entities controlled by TriWest Construction Limited Partnership (TriWest LP). Martin remained president and retained an indirect interest in the businesses upon the sale, through limited partnership units in TriWest LP.

As part of the sale, Martin signed limited partnership and employment agreements containing non-competition and non-solicitation covenants. The relevant features of the covenants included the following:

The prohibited geographical area was Canada-wide.

The prohibited period ended 24 months after Martin disposed of his indirect interest in ConCreate and SDF. However, Martin could not dispose of his interest without the approval of the board of TriWest LP’s general partner, ConCreate, SDF and their respective lenders "from time to time."

The prohibited activities included activities that ConCreate and SDF did not engage in at the time of the transaction, and they extended to customers of the business at the time of the transaction and at any time thereafter.

Martin’s employment as president was terminated less than six months after the closing of the sale transaction. Soon thereafter he started a company that allegedly competed with ConCreate and SDF. His new company also employed former ConCreate employees, including former members of ConCreate’s management team.

ConCreate and SDF commenced an action against Martin, claiming that he had breached his restrictive covenants. Martin then applied for a declaration that the restrictive covenants were void and unenforceable as being unlawful restraints of trade. This application was dismissed, and Martin appealed to the Court of Appeal.

Court of Appeal’s Decision

The Court of Appeal found that the restrictive covenants were unenforceable. In its decision on February 5, 2013, the Court took no issue with the geographic scope of the covenants (Canada-wide), as there was a legitimate business interest to protect nationally. However, the Court found that the duration was unreasonable because it depended on obtaining consents from third parties. This meant that the duration was indeterminate, rather than fixed. The following additional factors informed the Court’s decision:

The third parties whose consents were required included unascertainable future third parties. Martin was required to obtain consent from, among others, the general partner’s principal banker "from time to time" and the lenders to the partnership and its subsidiaries "from time to time." As the identity of these third parties could change, it was unclear whose consent would be necessary to dispose of his interest.

The third parties owed no contractual duty to Martin to act promptly or reasonably. Indeed, they could have an interest in limiting his competitive activities and thus could unreasonably withhold their consent out of self-interest.

While this point was not determinative, the Court was also troubled by the fact that the duration of the restrictive covenants was tied to the period during which Martin retained his indirect interest. The Court noted that the typical non-competition covenant obtained on the sale of a business is calculated from the date of the transaction or, if it applies to an employee, runs for a specified period after termination of employment.

Having found that the restrictive covenants were unenforceable due to their unreasonable duration, the Court did not have to decide whether the scope of the prohibited activities was reasonable. While this point was not determinative of the appeal, the Court found that the scope of the prohibited activities was not reasonable and went far beyond what was required to adequately protect the goodwill of the purchased business. The Court found that it was unreasonable that the restrictions in the non-solicitation clause extended to communicating or dealing with any persons who were customers, dealers, agents or distributors of the business "at the time of the sale transaction or afterwards" (emphasis added). The Court also found that it was unreasonable that the covenant was in respect of products or services "whether or not offered, or planned to be offered, by ConCreate or SDF at the time of the sale transaction" (emphasis added). The Court noted: "It is not reasonable for a restrictive covenant, given in the context of the sale of a business, to extend to activities neither carried on nor in the parties’ contemplation at the time of sale, while the covenantor was involved in the business post-sale, or even while the covenantor had an ownership interest in the business."

The Court acknowledged that the law distinguishes between restrictive covenants in connection with the sale of a business and those in an employment context. It noted that a less rigorous test should be applied in determining the reasonableness of a restrictive covenant on the sale of a business, as such a covenant "may be required to protect he goodwill sold to the purchaser, and does not usually involve the imbalance of power that exists between employer and employee." However, the Court noted that this did not "entirely immunize the clause from scrutiny." The Court confirmed that it would engage in a rigorous analysis of the reasonableness of restrictive covenants entered into on the sale of the business.

Implications

Parties negotiating restrictive covenants on the sale of a business should be very careful to ensure that the restraints are justifiable to protect legitimate business interests and are reasonable. What is prohibited must be as simple as possible and clear as to geographical scope, time and activity. The geographical scope must be no greater than the area in which the business is being carried on at the time of the transaction, or as reasonably contemplated by the parties at the time of the transaction. The prohibited time period must be fixed and certain. The restricted activities should not extend beyond those activities carried on or in the parties’ contemplation at the time of the sale, during the individual’s involvement in the business post-sale or during the period of the individual’s ownership interest in the business post-sale.

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1 2013 ONCA 72.

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